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WE HAVE NOT SEEN THE WORST YET
The economy has not hit bottom yet, says Gary Shilling. Neither, in all likelihood, have stocks.
Gary Shilling has been a deflationist bear for a long time, but not a self-promoting one (unlike some others who shall go nameless). Essentially all the investment advice he has given the past several years has worked out well. So when he says that there is further to go, and that it is not too late to pull money out of the stock market, one would probably do well to listen. And he does say both of those things.
Where is the economy headed now? Do not be misled by the global stock market rally that flared up after governments in Europe and then the U.S. announced their direct purchases of bank shares. Instead, consider the Bronx cheer that greeted the $700 billion bailout law. That market meltdown was caused by shareholders finally anticipating the economic pain I forecast two years ago (in my June 19, 2006 column, "Implosion"). The overarching reality is that both households and financial institutions are unwinding the immense leverage they built up over three decades. That deleveraging is far from complete.
Sadly, Washington policymakers are only partly cognizant of this new reality. Instead, they react ad hoc to each new crisis. The heads of banks and insurance companies are taking writedown after writedown, almost comically declaring after each that they have removed all the cancer and no further trips to the operating room will be necessary. Investors are treating each bailout as the last that will be needed, oblivious to further problems that continue the market's sawtooth pattern along a steeply declining trend.
The deleveraging is occurring in four phases. The first, the collapse in housing, started early last year when the subprime slime, as I dubbed it, came out into the open. Phase two, Wall Street's woes, began in mid-2007, when the demise of two Bear Stearns hedge funds revealed that financial firms were hugely leveraged and invested in overpriced assets of unknown and probably unknowable value.
These two phases are continuing. Housing prices are down 18% and will drop 23% from where they are now to reach the 37% total peak-to-trough falloff I foresee (see chart). Excess inventory, the mortal enemy of prices, now amounts to 1.8 million homes, which is a huge number relative to the net demand (new families minus departures to death and nursing homes), which is only 1.5 million a year. Meanwhile, the shared confidence that glues financial markets together has deteriorated to the point where banks do not want to lend to one another, much less to anyone else. The demise or rescue of Bear Stearns, Lehman Brothers, Fannie Mae, Freddie Mac, Washington Mutual, AIG, Wachovia and the money market fund industry has only added fat to the fire. The easing of mark-to-market rules will make bank balance sheets less scary-looking, but it will not necessarily reassure investors, who will be all the more apprehensive about losses they are not allowed to see.
Until recently the goods and services side of the economy was holding up. Real GDP fell slightly in the fourth quarter of 2007 but rose in the first two quarters of this year. Most economists, who are paid to be optimists, are only now coming around to the view that the economy is in a recession. I put less stock in raw GDP figures and peg the recession as having started late last year. In any event, the severe damage to the financial structure simply has to drag down the goods and services side. That fact is what persuaded politicians to commit to spending $700 billion to bail out the banks even though their constituents think Wall Street is run by overpaid crooks.
Phase three of the recession, the nosedive in consumer spending, will probably be the deepest since the 1930s. Consumers have relied on their home equity to fund spending well beyond their wages, salaries and other income, and that equity is fading fast, especially for those with mortgages (see chart). The collapse in house prices will, I expect, leave 25 million homeowners stuck with homes collectively worth $1 trillion less than their mortgages. Even including the 24 million who own their houses free and clear, 1/3 of homeowners will ultimately be underwater.
With little room to borrow, consumers are retrenching, and they are slashing their discretionary purchases, as I explained in my Sept. 29 column ("Worse Is Yet to Come"). That means forgoing not only cars and ocean cruises but also smaller items like dinner out and Christmas gifts. Also, consumers are beginning to regard payments on home equity, credit card, auto and other loans as discretionary outlays. When the choice is between making the credit card payment and putting bread on the table, financial integrity loses out. JPMorgan Chase recently reported it was charging off credit card debt owed it at a 5% annual rate. Charge-off rates will get a lot worse than that.
The combined $4.6 trillion in those four loan categories (second mortgage, credit card, auto and other) makes the $700 billion in subprime debt look like chicken feed (see chart). Financial institutions own a lot of those loans, directly or through securitizations, and they may suffer even bigger woes than from the subprime slime.
Unlike housing, commercial real estate was not overbuilt in recent years, but prices were bid up. Commercial real estate is backed by $3.5 trillion of debt, again heavily owned by financial institutions. In today's climate, declining demand may be devastating. Malls will suffer and tenants fold as consumers retrench. Warehouses will stand empty as consumers cut spending on both domestic and imported goods. Hotel occupancy will continue to slide. Layoffs will hurt the office space market, and those still employed will occupy less space as the partitions are moved in. Hospitals will have trouble covering their mortgages, as pressed consumers forgo elective procedures.
The recession will probably be the deepest since the 1930s, especially as it spreads globally in its fourth phase. Weak consumer spending in Japan and Europe, housing collapses in Ireland, Spain and the U.K., and the spreading financial crisis are already hobbling exporters in China and India. Think about the bankruptcy of Iceland and the stock markets collapsing around the globe, particularly in Russia, where the oligarchs are getting knocked down by big margin calls. Think about the bailouts of HBOS, Bradford & Bingley and the Royal Bank of Scotland in the U.K., of the French-Belgian bank Dexia, the Dutch-Belgian bank Fortis and Hypo Real Estate in Germany. The countries of Europe are in a protectionist-tinged race to guarantee bank deposits and loans and take ownership stakes in banks. That is what forced the U.S. Treasury to shift $250 billion of its $700 billion in bailout money to buying bank shares.
Moreover, commodity prices are collapsing as global demand falls and as those who thought commodities were a legitimate investment rush out even faster than they charged in. The dollar is rallying as everyone flees to Treasury bills.
The profits of nonfinancial U.S. corporations are extremely vulnerable as domestic and foreign sales plunge, credit markets remain chaotic and the transfer of foreign earnings into dollars turns from a buoy into a millstone. That will help sink the $2.6 trillion in leveraged loans and $1.1 billion in junk bonds out there and push many investment-grade companies into junk status.
Getting out of this financial mess will require the elimination of excess housing inventories, completion of the writedowns and recapitalizations at financial institutions and the subsidization of underwater homeowners' mortgages. That could all take years and cost -- who knows? -- $3 trillion. On top of that, the likely disasters with consumer loans, commercial real estate and junk securities will take time and money, too.
If you are an equity investor with a long-only portfolio, it is not too late to take some money off the table. Remember 777 -- not the airliner but the low that the Standard & Poor's 500 hit in 2002. That is 21% beneath where we are today (only 11% lower as this is posted), but if it is breached, then all the stock rise of the last six years will have been but a bear market rally, and the bear market that started in March 2000 will still be with us.
THAT WAS WAY TOO CLOSE FOR COMFORT
Amid massive losses, some words for the wise.
This past Friday's financial markets action was a “close run thing,” as the Battle of Waterloo and later the Battle of Britain were described. Facing possible meltdown in the morning, the stock market recovered to “only” close at a new bear market low. The Dow Industrials closed down 5.3% for the week (last week's chart here).
This Barron's piece provides a useful survey of sorts on the various opportunities which have arisen amidst all the dislocations, particularly in certain areas of the credit markets that equity-oriented investors are likely to overlook. For example, convertible bonds now offer double-digit returns to go along with the potential equity kicker, as this supposedly low risk alternative to common stocks has instead declined as fast as the overall market. This is unprecedented in our personal experience. Other unusual pricing is the result of the appearance of an illiquidity premium in now thin markets, even where apparently identical or superior alternatives trade with no premium in liquid markets. Presumably that will eventually disappear, but it may be a while.
The U.S. stock market avoided a meltdown Friday (October 24) after a scary opening as investors worldwide start to anticipate one of the most severe global economic downturns since the Great Depression.
While not massive, the losses Friday were hardly encouraging as the Dow Jones industrial average finished with a decline of 312 points to 8378 after pre-market indications that the benchmark average could open with a loss of 500 to 600 points. The Dow industrials finished at a new closing low for 2008, as did the Standard & Poor's 500 index. The Dow and S&P 500 fell 5.3% and 6.8%, respectively, in the five sessions, reversing big gains registered in the prior week. The Dow now is down 37% so far this year while the S&P 500 has lost 40% and the Nasdaq 41%.
The losses are massive on a global scale, with the major markets down at least 40% this year. In the U.K., the FTSE 100 is off 40% as the British economy slides into recession, the French CAC 40 is down 43% and the German DAX 47%. European markets are at 5-year lows while the Dow and S&P are holding above their 2003 lows. In Asia, the Nikkei 225 has dropped 50% to 7,649. Emerging markets have suffered huge declines, with Russian stocks down 76%, Brazil off 50% and China down 65%.
Wall Street seems resigned to a recession in 2009 and the debate has shifted to whether the global economy will slip into depression, a scary prospect.
Ray Dalio, who heads Bridgewater Associates, a Westport, Connecticut global investment firm that manages $150 billion in assets and is known as a currency and bond specialist, has been warning clients that the world is entering a depression caused by an irreversible deleveraging spiral in which super-low interest rates will have little economic impact. "We are in for a multi-year period of pain and the degree of pain will depend on policy responses," Dalio has told confidantes and clients. Dalio, who was last interviewed by Barron's in May 2007, has been reluctant to talk publicly for fear of exacerbating the worries of already nervous investors.
Companies ranging from American Express to UPS to Daimler are warning of weakening business conditions as consumers and businesses pull back worldwide. The U.S. jobless rate, now 6.1%, could hit 10%.
The good news is that governments around the world recognize the problems and are responding in unprecedented fashion to prop up banks and other financial institutions. Sharp declines in commodity prices, including oil, which is down over 50% from its summer peak of $147 a barrel to $64, will help both individuals and businesses, mitigating some of the economic weakness.
It is important that Warren Buffett has turned bullish, writing recently in the New York Times that he is buying American stocks. "I haven't the faintest idea as to whether stocks will be higher or lower a month -- or a year -- from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over," Buffett wrote.
Valuations of stocks look pretty reasonable, even assuming marked earnings declines. The S&P 500, at 876, is trading for just 10 times 2007 operating earnings of $85. This year's profits will be a disaster due to write-offs and losses, and the 2009 earnings outlook remains uncertain. Citigroup analysts see $79 in S&P earnings, but even assuming $70, the index is valued at less than 13 times earnings. The dividend yield on the S&P 500 stands at 3% and the price/book ratio is 1.8 times, versus 3.3 a year ago.
European stocks are even cheaper, trading with a 6% average dividend yield and at just 1.2 times book. European equity yields have not been so attractive relative to European bonds in 50 years.
Barron's has suggested that cash-rich companies like Microsoft (MSFT), ExxonMobil (XOM), Loews (L) and Motorola (MOT) look attractive in the current environment. Debt-laden companies have been among the worst performers recently. Real-estate investment trusts have fallen about 45% in the past month, and leveraged casino operators like MGM Mirage and Las Vegas Sands have been slammed.
Perhaps the most overvalued big company on the planet remains Volkswagen (VOW.Germany), the European auto maker whose shares fell 40% to €210 last week but still trade at a big premium to rivals like Daimler (DAI) and BMW (BMW.Germany). Barron's wrote skeptically on VW recently. VW still fetches nearly 20 times earnings, while Daimler has a P/E of 5 and BMW just 6 based on projected 2008 profits. VW has benefited from a big short squeeze that has started to abate. Its shares could fall under €100, analysts say. Its market value of $84 billion is triple Daimler's, a seemingly nutty situation.
Near term, stocks may be due for a bounce because the recent declines -- 24% in the S&P 500 since October 1 -- have been so steep. The S&P 500 was trading Friday at about 25% below its 50-day moving average. Since 1928, there have been only five such instances, including the aftermath of the 1987 market crash. Each instance was followed by a rally in the next 50 days, according to Bespoke Investment Group.
There were some bright spots in financial markets last week, notably municipal bonds, which had one of their biggest one-week rallies ever as long-term yields fell roughly a percentage point to around 5%. Barron's highlighted the allure of munis last week.
The greatest margin call of all time.
Talk to professional investors and they say some of the best opportunities lie outside stocks in such areas as convertibles, leveraged loans and interest-rate swaps. These markets have been swamped by massive sales by leveraged hedge funds.
Strategist Ed Yardeni called selling by the $1.7 trillion hedge-fund industry the "greatest margin call of all time." The impact is apparent in the strength of the Japanese yen, which surged 3% Friday to 94 yen to the dollar, capping a month-long rally of 12%. Many hedge funds borrowed in yen to finance their leveraged trades because yen rates have been below 1%. Now that these trades are being unwound, the hedge funds have to buy back the borrowed yen at a big loss. European hedge funds are being hit even harder because the yen is up 23% against the euro in the last month.
Convertibles, featured in the article, Convertibles: the Chicken Way to Play, have never looked so attractive after declining a record 36% this year (measured by total return). Investors now can get double-digit yields and equity exposure via converts. The junk bond market also is suffering its worst year in its history with a drop of 25%, according to Merrill Lynch. The result is that the average junk bond yields a stunning 19%, versus about 8% a year ago.
Bank loans to highly leveraged companies also have come under severe pressure this year as hedge funds and others that bought them with leverage of 3-to-1 or higher have been forced to sell. Many leveraged loans are selling at 60 to 80 cents on the dollar, down from around 100 in early 2008. Leveraged loans are yielding 10% to 20% and benefit from seniority in corporate capital structures. Debt from the likes of Neiman Marcus, Realogy and Harrah's Entertainment trades for 60 to 70 cents on the dollar, allowing investors to buy into these companies at a fraction of the price paid by private-equity firms in the past year. Individuals cannot play directly in leverage loans, but there are a few closed-end funds, including the Van Kampen Senior Income (VVR) that focus on the sector.
Takeover arbitrage situations also offer rich returns because investors fear that companies will not get financing for all-cash deals. Anheuser-Busch (BUD), for instance, fell six to 57 last week (on Monday it partially recovered to 60), ending considerably below the $70 takeover price from Europe's InBev (INBVF). The $52 billion deal for the Budweiser brewer, which is expected to close by year-end, does not look so smart now for InBev, whose stock is down 33% to €28 in the past month.
As Wall Street firms like Goldman Sachs and Morgan Stanley have pulled back from the markets, seeking to preserve capital and reduce leverage, many anomalies have cropped up. One is in the derivatives market, where 15-year Treasury debt yields more than similar-maturity interest-rate swaps, which are bank obligations. The 15-year Treasuries yield nearly a half percentage point more than swaps, while typically they yield 1/2 percentage point less.
This is hard for swap participants to fathom because risk-free Treasuries ought to yield more than swaps. Why such a weird situation? Trading desks on Wall Street do not want to take proprietary positions, hedge funds are reeling, and banks seem loath to bulk up on what appears to be a virtually risk-free trade for an investor with staying power. "Until recently, those levels would have been dismissed as inconceivable, based on the cash-flow analysis of an asset swap that is held to maturity," wrote RBS Greenwich Capital derivatives strategist Fidelio Tata last week. Such a dislocation, he calculated, theoretically is a "7-sigma" event, which means it should happen once every 14 billion years, which is roughly the age of the universe.
Obviously, derivative market participants have understated the odds that illiquid markets will produce unprecedented developments. Stocks and other asset classes, like convertibles and junk bonds, may not represent a once-in-a-14 billion-year buying opportunity, but patient investors who heed Buffett's advice should do well.
Opportunistic? Then Start Making a Buy List
Vigil for the “final panic.”
If you have not already created a buy list then it is time to get going. The market will get cheaper if Gary Shilling (above) is correct. Conceivably you may not end up putting the buy list to use for a while. But with so many stocks so cheap it is definitely time to start looking through the wreakage.
Mike Tyson is credited with observing, when told of his opponent's expected fight strategy: "Everyone has a plan ... until he gets hit."
True enough, as many investors and traders who planned methodically to raise stock exposure into the October selling storm have learned. Guided by a variety of once-reliable signals encompassing valuation, sentiment and Buffettology, the airwaves and printed page offered the common sober advice to begin rotating back toward stocks.
Just three weeks ago, this column humbly ventured that an investor shunning the folly of plucking a precise market bottom should simply bid to buy the market 10% below the then-current index level. That bid was hit -- quickly, repeatedly and hard. Such an investor is now underwater by some 11%. So, yes, well-drawn plans retain their air of logic until the leather hits the jaw.
Even those who watch the televised tape with the sound muted have been beaten over the head with the explanation that "forced liquidations" by hedge funds and others are to blame for the latest down leg.
This, to some indefinable degree, is why the market has refused to bottom synchronously with numerous perfectly appropriate plot points. These include -- aside from the serial government bailout efforts -- the passing of the Lehman and Washington Mutual credit-derivatives settlements, the easing in short-term funding markets, the marking of the anniversary of the 1929 crash and margin calls on octogenarian corporate CEOs.
This should squelch the temptation to conjure further perfectly ironic script elements that might trigger a recovery. (Will General Motors be ousted from the Dow industrials? Will some formerly idolized mutual-fund manager be bounced from his fund?)
Still, if forced liquidation is the moment's proximate villain, then we should at least eye potential signs of its capture. Among the things to look for is a multi-day pause or reversal in the dollar's rise, which could mean the global rush to grab dollars to repay dollar-based liabilities is easing. And it would not hurt if one of the whales presumed to be struggling below the surface washed up on the beach, in the form of a truly huge name-brand hedge fund folding.
Watch and learn, while allowing for the chance that "forced liquidation" is eventually added to the list of straw men blamed for the market collapse.
An immediate test of whether the market's traditional rhythms are intact will arrive soon, as the coming week ushers in some of the more bullish seasonal patterns in the historical record. Not only does folklore tell us to buy after the World Series and sell at the Kentucky Derby (or something like that), but McMillan Analysis has pinpointed October 27 (after the close) to November 2 as one of the strongest stretches of the calendar. If it fails, it will be one more mark against the almanac's market wisdom.
So was it all just a happy dream, the bull market of 2002-2007, which at the recent lows had nearly been entirely extinguished? For sure, the economy and credit markets were animated by a prolonged sugar high from easy money, with stocks dragged along with them. But equities got cheaper throughout, implying more than mere reverie was at work, and thus some value is to be located in the wreckage.
There is a way to look from a certain angle while standing on one foot and conclude that Friday could prove a "low-volume re-test" of the October 10 intraday lows, which were not quite revisited.
But the drift-like narrowing of the losses all Friday afternoon after the early-morning drop was not all that convincing. Individuals showed a bit too much hope by ceasing to cash out of stock funds in the latest week. Carpenter Analytics' gauge of hedge-fund positioning has failed to get to bear-market extremes of short exposure. Nasdaq reported Friday that short interest in its listed stocks fell 10% in the first half of October, again complicating the vigil for "final panic."
Still, an investor not moved to begin compiling a buy list, for gentle implementation, with the indexes down 44% in a year and two weeks is not truly in the business of contrarian or opportunistic investing. All an investor can control is the price at which he or she is willing to own a stock, not where the price goes from there. Just don’t call it a plan.
HISTORY’S BIGGEST MARGIN CALL
The entire world was seemingly positioned for a particular financial backdrop and received an altogether different one. Some years ago I wrote something to the effect that "financial crisis is like Christmas." After all, during the Greenspan era periods of heightened financial and/or economic pressures were almost cause for celebration within the leveraged speculating community. Aggressive rate cuts and "easy money" were the trumpeted solution to any problem, which equated to easy financial fortunes for the savvy market operators. Over time this culture of leveraging, speculation and financial shenanigans fanned out across the globe -- throughout finance, commerce and government endeavors.
This mindset was firmly ingrained when our subprime crisis erupted in the spring of 2007. The whole world apparently was of the view that the unfolding U.S. mortgage and housing crisis ensured "easy money" as far as eyes could see. "Helicopter Ben" was at the controls; dollar devaluation was in full-force; dollar liquidity was barreling out of the U.S. credit system; financial systems across the globe had succumbed to credit bubble dynamics; inflationary fires blazed everywhere; and speculative finance was literally inundating the world. In most places, making "money" had never been so easy.
This backdrop created epic price distortions and some incredibly mal-aligned market perceptions. It is now clear that unprecedented leverage became deeply embedded in markets and economies everywhere. These excesses had been unfolding over a longer period of time, but terminal speculative "blow off" dynamics really engulfed the global economy when U.S. housing vulnerability began to emerge. A confluence of many extraordinary and related dynamics was severely undermining the global system. The U.S. financial sector was desperately overheated, the U.S. mortgage/housing bubble was bursting, the expansive international bubble in leveraged speculation was in "blow-off" mode, global imbalances were at dangerous extremes, and inflationary psychology took hold throughout global financial systems, asset markets and real economies. It was an unparalleled period of synchronized global credit, asset market, and economic bubbles.
Only today is it readily apparent what a mess the global pricing system had become. Think in terms of a net trillion plus U.S. dollars inflating the world each year, of which a large part was recycled through Chinese and Asian purchases of U.S. securities (inflating domestic credit systems and demand in the process). Think in terms of rapidly inflating economies with several billion consumers (Brazil, Russia, India, and China). Think in terms of the surge of inflation that forced thoughtful policymakers in economies such as Australia, New Zealand and elsewhere to significantly tighten monetary policy. Rising rates, however, only enticed more disruptive speculative finance flowing loosely from (low-yielding) credit systems including the U.S., Japan, and Switzerland. Speculation could have been as simple as shorting a low-yielding security anyplace to finance a higher-returning asset anywhere. Or, why not structure a complex leveraged derivative transaction that, say, borrowed in a cheap currency (e.g., yen or swissy), played the upside of rising emerging equities markets, and at the same time had triggers to hedge underlying currency and/or market exposure. And the counterparty exposure for a lot hedges could be wrapped up in collateralized debt obligations (CDOs).
And the more loose global finance inflated the world, the more the leveraged speculating community inundated "commodity" economies such as Australia, Canada, Brazil, South Africa and Russia. Of course, speculative inflows ignited domestic asset market and credit systems, in the process fostering dangerous bubbles. And in concert with the deflating dollar, speculating on virtually any emerging market or commodity was immediately profitable. The more leverage the stronger the returns, and the world was introduced to the concept of the billionaire hedge fund manager. In commodities markets, wild price inflation and volatility forced both producers and commodity buyers to employ aggressive hedging strategies. More often than not, derivatives employed trend-following trading mechanisms. These "hedging" mechanisms covertly created huge buying with leverage on the upside and, more recently, liquidation and a collapse of prices and leverage on the downside.
It was Hyman Minsky "Ponzi Finance" on a grand scale. It was also a bout of George Soros "Reflexivity" of epic proportions. The more markets perceived a New Era of endless cheap finance and rising asset and commodities prices, the more U.S. and global credit systems created the necessary inflationary fuel to perpetuate the bubble. Markets believed the hedge fund and private equity game could go on indefinitely. Participants thought that Wall Street would securitize loans and be in a position to expand finance forever. Prime brokers would always be willing outlets to finance leveraged securities holdings on the cheap.
The derivatives market would always provide an efficient and effective marketplace for placing bets, as well as for hedging myriad risks. Why not speculate aggressively when insurance was so easy to obtain? At the same time, contemporary "repo" and money markets were viewed as an endless source of inexpensive finance. And, in the event of anything unexpected, the Fed (and global central bankers) would always ensure liquid markets -- and inflate as required. Again, why not speculate? The markets had unwavering faith in enlightened contemporary finance and central banking.
But it was all part of the greatest mania in human history. As it turned out, the markets could not have been more wrong on the sustainability of the financial backdrop, the economic environment, asset price inflation, and all types of sophisticated financial structures and strategies. Markets were not only absolutely wrong, they were absolutely wrong on so many things on such an unprecedented global basis. Now things are blowing up. In the thick of it all, confidence in the securitization, "repo" and derivatives markets has been broken.
As a result, Wall Street simply no longer has the wherewithal to apportion ample finance for securities speculation. Without speculative demand for high-yielding loans and securities, Bubble economies are starved of sufficient finance. And with asset markets bursting everywhere, this has quickly evolved into History’s Biggest Margin Call. Scores of derivative structures used to speculate in the asset bubbles have collapsed -- because of counterparty issues, illiquidity, or the structures just did not make any sense to begin with. Moreover, the whole notion that derivatives would provide an effective hedging mechanism is proving a fallacy. Again, counterparty issues and illiquidity are the culprits. Markets cannot hedge themselves, as there is no one with the wherewithal to take the other side of the trade (especially during devastating bear markets). In particular, the credit default swap structure is proving an unmitigated disaster -- for bond, equities and currency markets. Hopefully this period of liquidation and deleveraging is over very soon.
THE TRUTH ABOUT DEFLATION
The transition from today’s “disinflation” to inflation will be chaotic, and thus untradeable.
In tossing around the various theories about inflation/deflation sooner/later we ultimately were reminded of a quote we read from a Forbes magazine quotes page many years ago. Some French gentleman said something like: “I used to have six theories about raising children. Now I have six children and no theories.” Perhaps this is a signal that we should just take the advice of investment newsletter writer and self-promoter extraordinaire James Dines: “Don’t think. Look!”
Then we ran across this piece by Eric Janszen from newly-discovered site iTulip.com. The critical element of his "Ka-Poom Theory" is that there is no such thing as runaway deflation in a fiat currency world. All true deflationary spirals in history came under a gold standard. If you observe deflation in a fiat currency world it is only because the central bank allows it to happen.
Janszen labels today's temporary deflation "disinflation" -- somewhat confusingly but we guess intentionally using a label that in the early 1980s was used to refer to declining inflation that did not go negative. Today's disinflation is the artifact of a temporary dollar shortage (see posting immediately below) that will eventually resolve into real inflation. He warns, off the cuff, that the transition will be chaotic and thus one should not try to trade it -- although he could not blame his readers for trying.
With all of this panicking into dollars we get asked a lot about deflation. "Why don't you just admit that a 1930s style depression and deflation spiral has begun and soon there will be soup lines and we will be buying cars for $2,000 and gold will trade at $100." The reason is that we are 100% certain that dollar appreciation that we call "Ka" as part of Ka-Poom Theory will not turn into a deflation spiral. Cars are not going to cost $2,000, although there will be plenty of cheap used cars for sale, and gold will not go to $200. Here is why.
The essence of Ka-Poom Theory is that after the phony credit-based boom ends, first the dollar rises and inflation falls before dollar repatriation and government reflation policies kick in. We do not think the transition from disinflation to inflation is tradeable because we expect it to be chaotic. But we do not blame readers for trying, or wanting to.
We are not nitpicking terminology here. We will show you what a real deflation spiral looks like: nothing whatsoever like the deflation we are seeing today that we have long forecast and call disinflation to distinguish it from the runaway deflations that occurred under the gold standard in the pre-Bretton Woods era.
Deflation was common back in the days when there was something for a currency to deflate against for more than a brief period of time before the government got involved: gold. Even then, governments often abandoned the gold to inflate the money supply to stop deflation, especially in times of war. If you are a government and need to inflate and there is no war to fight, then make something up -- like a oil shortage in the 1970s.
Note (see chart) the early 1920s deflation reached -30% in some months and on and off for years at a time. Note also the massive inflations produced as the U.S. government temporarily suspended gold convertibility and printed money to fund wars. Many forget that these huge swings occurred: 80% inflation during WWI and 100% inflation after WWII. Governments can always produce inflation. Always.
The period of deflation that occurred in the early 1930s (see chart) is the one that most people think about when they hear the word "deflation." What they really mean is a deflation spiral, with the money supply imploding, credit contacting, large scale bankruptcies, rising unemployment, and falling economic output. Note that there was not a single month of inflation from 1930 to 1933. Prices went down and down and down. For years.
The 1930s deflation spiral ended abruptly in 1934. Why? FDR took the U.S. off the gold standard and devalued the dollar against gold which remained the international currency for trade transactions. And -- this is key -- there has never been another similar period of deflation since then, in any country. Ever.
There is a reason for that: since the 1930s no country has been on a national gold standard.
Only one other government made the choice to stay on the gold standard at the time, Germany. Every other government got off the gold standard in the 1930s and inflated. Many, such as the U.S., finally resorted to currency depreciation when the pain got bad enough, exporting deflation. That was the impetus for Bretton Woods after the war: Do not allow a repeat of competitive currency devaluations because nations in a global depression that fight each other with currencies are soon fighting each other with guns.
There were a very brief few months of deflation after WWII as the government attempted, Paul Volcker style, to wring inflation out of the post WWII economy (see chart). But note the deflation scale in this post-Bretton Woods period has now changed from the post-gold standard era where deflations exceeded 30% in some periods. Since then, no more 30% deflations. Rarely, for short periods when deflation has happened since Bretton Woods, deflation has only once exceeded 10% in one month and has generally been limited to less than 5%.
The first years of the 1960s were the golden era of monetary stability (see chart). In fact, life was so good the U.S. government decided to ruin it by starting a war, building the military industrial complex, and launching numerous entitlement programs that we are to this day still kidding ourselves into thinking we can pay for. After running up a trade deficit that our trade partners feared we intended to pay with devalued dollars, the Europeans figured we were cheating and called our bluff by demanding payment of debts in gold. So we defaulted. U.S. to the world: Thanks for playing!
This was the ugly era of birth of the FIRE Economy. I will not go into the details here but, clearly, deflation was not the problem (see chart). I will mention that this is when we came up with the dollar cartel to knock back OPEC and Nixon got to tell OPEC: "Thanks for playing!"
As the Volcker Fed raised interest rates, the U.S. economy experienced a short spike of deflation around -5%. Since the technology stock bubble popped in 2000, the U.S. has had several months of deflation like that in 2002, 2004, 2006, and 2007.
If you want to call today's period of low inflation a "deflationary period" then you must also call 2002, 2004, 2006, and 2007 deflationary -- actually more deflationary than today if you look at the graphs. Meanwhile oil increased from $20 to $147 over that period, which is not exactly a typical symptom of deflation.
Japan also has never experienced a deflation spiral. They could end their modest deflation, never exceeding -2% in a quarter off and on for more than a decade in short order, but the trade-off for them is a crashed yen -- so they do not. I think we will crash the dollar fighting off deflation.
The critical take-away is that we are indeed experiencing short term deflation. We call it disinflation here in the context of Ka-Poom Theory to keep readers from confusing the process with the start of a deflation spiral -- which cannot happen under a floating exchange rate, fiat money system. The only way it could is if governments around the world all got together and decided to crash the global economy. That strikes us as unlikely. More likely one or more will move to reflate using currency devaluation.
If the Fed so desired the U.S. could have 100% inflation by the middle of 2009 as the U.S. did in 1946. All that is needed is for Congress to borrow a few more trillion into existence to fund old and new liabilities and have the Fed print it because our government cannot borrow the money from overseas or raise taxes, or devalue the dollar, or both.
It is just that simple. Wish it was not so. Trust your government not to do it? Neither do we.
If not deflation, then what? Stagflation?
Keep an eye on producer price index, commercial lending rates, and wage rates. These tell you how much your local grocery stores, restaurants, gasoline stations, and other businesses have to pay -- their input costs -- as the recession drags on. As recession deepens, businesses have to cut prices to their customers to meet lower demand. If input costs do not fall quickly, many of these companies will either go out of business or be acquired by stronger rivals that have more cash or access to credit. If this goes on for years, as we expect it to, instead of a short drive to the local Home Depot it is a long drive, instead of 10 restaurants to choose from in the area there are five, instead of four grocery stores to visit there are two, instead of four daily flights to your favorite destination from the nearest airport there is one. The plane is crowded. You are packed in like a sardine. The fare is expensive.
Inflation comes not only from surfeit of money relative to goods and services but also a shortage of goods and services relative to the supply of money.
In a couple of years when you get to the one remaining Home Depot in your area that has not closed you will find that it is crowed. As most of the goods that Home Depot sells are imported, and the dollar continued to decline after the current short-term panic into dollars ends -- and the impact of net negative capital flows exerts its natural downward pricing on the dollar -- the wholesale prices Home Depot pays will not decline much if at all. The government will welcome the devalued dollar, as it has since 2002, because the inflationary impact helps counter the deflationary impact of debt deflation and helps the U.S. export position. Wage rates will not rise because recession will have caused higher unemployment and reduced wage earner's pricing power. However, at that point there will be few stores (boom market in plywood to cover plate glass windows?) and two or three times as many consumers vying for the same goods, and the cost of imports is up because the dollar had depreciated further. Prices may actually rise.
In response, consumers will buy fewer things and will substitute lower quality products for higher quality products, hamburger for steak. The golden age of the American consumer ends.
Let us say you are an American visiting an indebted country years ago that has lost its ability to extend its purchasing power via foreign borrowing because that is the situation that the U.S. faces today. For example, Mexico in the early 1980s. What do you see? You spend your strong dollars so experience prices there as cheap. You see crowded stores and low prices -- crowded because the equilibrium price between the cost of goods that stores pay and prices that customers can afford creates only enough demand to support a small number of stores for the local population. But the people who live there experience the same stores as crowded but with high prices. Why? Because while the new equilibrium price for goods is now the same as before or maybe higher, but the purchasing power of consumers has fallen due to lack of access to credit and falling incomes.
That is our future in the U.S. once the spike in the value of the dollar ends and the dollar continues its decline through this recession. This picture may, however, be distorted by government intervention to support the housing and credit markets to slow debt deflation. Government spending may further weaken the U.S. dollar. Then there is the possibility that immigration and trade policy will change to address wage deflation by lowering competition for jobs via restrictions on outsourcing and immigration.
The Real Reason Why the Dollar Is Soaring
We have been previously unacquainted with Rick Ackerman, whose site features "Rick's Picks: phenomenally accurate forecasts for stocks and commodities." Access to these picks is a paid service (you can get a 1-day free trial), and we have not verfied the "phenomenally accurate" claim. His commentaries are freely available, and based on our sample look commendably compact and to the point. This one below on the connundrum facing gold investors and speculators caught our eye.
The dollar may be "worthless," but debtors who cannot roll over their loans have to sell whatever they can to get enough "worthless" dollars to repay the loans and avoid going out of business. We have Rob Noland's "History's Biggest Margin Call" (above) at ground level. Asset prices fall against dollars, and -- voila! -- deflation. Much of the world's debt is dollar denominated, so the U.S. dollar appreciates against other foreign currencies as well.
Gold is among those quality assets that can be readily liquidated. Ergo, gold has been weak like everything else, even if that weakness is technically relative strength versus almost all other assets except cash. Just as trying to invest rationally during a bubble turned out to be a fool's game (everything went down), selling gold during an implosion risks getting caught being way underexposed when the worm turns -- possibly very suddenly.
The absurd spectacle of a short-squeeze driving a worthless dollar sharply higher is bound to make life difficult for gold bugs in the weeks and months ahead. If you are among those wondering what to do, you need first to understand that the dollar's surreal strength is not a flight to quality, as nearly all observers still seem to believe. Rather, it is due to the fact that those who owe dollars are unable to roll their loans and must settle up immediately in cash. We predicted this scenario years ago and reprinted the essay recently in our daily commentary.
One reason the mainstream media have failed to grasp the true reason behind the dollar's steep rise is that mainstream thinking is congenitally incapable of grasping the bluntly obvious fact that the dollar is fundamentally worthless. The Wall Street Journal's Peter McKay, for one, noted in a recent front page article that investors typically migrate toward the dollar in times of stress. But to think such a thing of Arab, European and Chinese investors is simply condescending, since they know as well as you and I that the trillions of dollars worth of bailout and backstopping commitments the U.S. Government has made in recent months can never be redeemed in fully valued dollars. Since this makes the dollar's collapse inevitable, foreigners would have to be very stupid indeed to be buying dollars by the truckload now for reasons of "safety," as the pundits and commentators would have us infer.
Challenging for Gold Bugs
For those who have been hoarding physical gold in order to tide themselves over in the hardest of times, the implications are challenging, to put it mildly. We delved into this a couple of weeks ago when we raised the possibility of gold spiking to astounding prices when the dollar finally collapses. Such an eventuality could make it well nigh impossible for hoarders to exit gold at the top -- and that is assuming there would be a clear choice of alternatives. But the more immediate prospect of a massive short-squeeze in the dollar, causing further, and perhaps severe, weakness in the price of gold, makes the challenge of holding onto one's bullion even more daunting.
There are two things to consider if you are worried that this is how things could play out. For one, and as we continue to emphasize, gold seems very likely to hold its purchasing power no matter what its price in dollars. And for two, it is possible gold will go no lower even if the dollar gets squeezed to the moon. Has gold perhaps bottomed already? We are open to the possibility, since its low last week came within a few dollars of an important downside target at 686 that we identified in the Rick's Picks chat room.
BUBBLES AND CAREER RISK
The dangers of left-brained bank bosses.
A couple of weeks ago we featured a Barron's interview with Jeremy Grantham. In response to a question about how on earth we got into this fine mess he responded to the effect that the types of people hired to run major companies are "left-brain doers" who focus on what is in front of them right now, as opposed to being those blessed with historical insight and thus having an intuitive awareness of the once-in-a-blue-moon events that can derail everything overnight.
In this Economist piece the whole idea is threshed out in finer detail. The lesson is the classic life lesson on the virtues of seeking balance. Boards of Directors need both right- and left-brained people on them, to keep fear and greed appropriately balanced.
As the global financial system fights desperately for survival, few people are more justified in saying "I told you so" than Jeremy Grantham, a Cassandra of the investment community since long before Nouriel Roubini became Doctor Doom.
Back in 2000, The Economist reported Mr. Grantham's comments at an event to mark the 75th anniversary of the publication of The Great Gatsby. The wealthy characters in the novel were "completely shallow," he said -- precisely the sort of "ineffable lightweights" who would have been unable to resist the temptation to join a crowd rushing into a stock market, and would accordingly have paid the price in the 1929 crash. As the article concluded, "He fears that a similar fate awaits today's investors."
Mr. Grantham's scepticism cost him plenty of business during the bullish years, as foolish investors preferred to share Gatsby's belief in "the green light, the orgiastic future." Yet, as The Economist reported this August, the mostly bearish 10-year forecasts issued in 1998 by Mr. Grantham's firm, GMO, "proved almost entirely correct."
So Mr. Grantham, a Brit based in New England, knows what he is talking about, which makes his latest GMO letter, "Reaping the Whirlwind," a must-read. He predicts further house-price falls in America and Britain, a sharp reduction in corporate profits everywhere, and that the Chinese government will "stumble" faced with the "spectacularly complicated task of maintaining the highest economic growth rate in history." Still, he admits to turning bullish on American shares, like another great investor, Warren Buffett, who last week wrote an op-ed in the New York Times advising people to buy them now. "If you wait for the robins," Mr. Buffett counseled, "spring will be over."
Mr. Grantham admits he will probably fall foul of the Curse of the Value Investor, which is buying too soon. Yet he is convinced that "by October 10th global equities were cheap on an absolute basis and cheaper than at any time in 20 years."
The most entertaining part of the letter is entitled Where Was Our Leadership? Mr. Grantham asks, "Why did our leaders encourage the deregulation, encourage the leveraging and risk-taking, and completely miss or dismiss the growing signs of trouble and what we described as the 'near certainties' of bubbles breaking?" Why, indeed?
He offers two theories. The first he calls Career Risk and Bubbles Breaking. The bosses of banks continued piling on leverage and taking ever greater risks because they felt they would be fired if they did not. "It is what I call the Goldman Sachs Effect: Goldman increased its leverage and its profit margins shot into the stratosphere. Eager to keep up, other banks, with less talent and energy than Goldman, copied them with ultimately disastrous consequences. And woe betide the CEO who missed the game and looked like an old fuddy-duddy. The Board would simply kick him out, in the name of protecting the stockholders' future profits, and hire in more of a gunslinger from, say, Credit Suisse."
The second theory reinforces the first, by combining the pressure for ever greater success with the selection of bosses ill-equipped to handle it. Mr. Grantham believes that chief executives are "picked for their left-brain skills -- focus, hard work, decisiveness, persuasiveness, political skills, and, if you are lucky, analytical skills and charisma." Great American executives are not picked for patience, he points out, plausibly enough. "Indeed, if they could even spell the word they would be fired. They are not paid to put their feet up or waste time thinking about history and the long-term future; they are paid to be decisive and to act now."
Only the rare person unconcerned with climbing the ladder, such as Mr. Grantham, spoke out about the looming dangers. (Turning bearish before the crowd certainly can involve serious career risk -- recall the late Tony Dye, who in March 2000 was fired as a chief investment officer at Phillips & Drew because he had moved out of what he rightly believed were overvalued equities and thus prompted many of the firm's clients to quit.)
According to Mr. Grantham, such people "have the patience of Job. They are also all right-brained: more intuitive, more given to developing odd theories, wallowing in historical data, and taking their time. They are almost universally interested -- even obsessed -- with outlier events, and unique, new, and different combinations of factors. These ruminations take up a good chunk of their time. Do such thoughts take more than a few seconds of time for the great CEOs who, to the man, missed everything that was new and different? Unfortunately for all of us, it was the new and different this time that just happened to be vital."
Ironically, those now in charge of the giants of the financial system are suffering from excessive risk aversion, scared of lending even to the bluest of chips. Now, says Mr. Grantham, left-brained bosses -- not the sort of cautious bureaucrat likely to appeal to the governments now overseeing the financial system -- are just what is needed. "The typical CEO is precisely equipped to deal with emergencies and digging out. Thus, Paulson was just the man to miss the point, but equally just the man -- or at least a typically good one -- to deal with a complicated crisis under stress."
As Mr. Grantham (or, to be precise, his wife) observes, the right- and left-brained should have come together on boards of banks, to keep fear and greed appropriately balanced. Yet, Sarbanes-Oxley and countless other initiatives intended to improve corporate governance seemed to have been largely ignored in the boardrooms of Wall Street, the City of London and Zurich. Let us give the last word to Mr. Grantham, who deserves his moment of schadenfreude: "What a shame that we have typically subverted this balance into a CEO fan club of old friends and mutual backscratchers."
IS GOLD OVERVALUED?
Mike Rozeff tries various approaches to estimating an equilibrium value of gold today, based on several different extrapolations from past periods of relative gold price stability. He comes up with a number of roughly $550 per ounce. By this line of reasoning gold's price decline since it hit $1000 in March and the current downtrend passing through the lower half of the 700's are justified. This says nothing about what gold should be based on possible hyperinflation down the road. That is a different matter.
In this article, I will make a case that gold's value is significantly less than its current market price of $735. Not being omniscient, I will not consider every factor that now or in the future may impact upon gold's price. But I will examine a few factors that, by themselves, suggest that gold is overvalued.
If gold is overvalued now, it could become even more overvalued. It could rise in price. I am not providing investment advice about whether or not you should buy or sell. I am merely providing some straightforward analysis that may or may not be of value to those of you who are players or potential players in the gold market.
Certainly there are scenarios in which the dollar disappears and gold is one of the last men standing that preserves wealth. Gold is insurance against being wiped out in these catastrophic scenarios. Anyone who thinks that these scenarios are imminent or even highly likely can disregard my comments. If the economic world of the dollar is going to end anytime in the next few years, then the difference between paying $735 for gold and paying $500 for gold will be irrelevant. I am making no comment about the likelihood of these scenarios, other than to say that they are more likely today, in my opinion, than ever before.
If, in your mind, the dollar already is a worthless piece of paper, then you will be thinking about gold in terms of a different metric than its dollar price. The dollar price will be irrelevant to you. You will be thinking about gold as a precious physical item because of its rarity, the difficulties and costs of finding sources and extracting it, and the long history of gold's purchasing power over goods. An ounce of gold will be your metric rather than the price in dollars of an ounce of gold.
Recently, I remarked to someone that gold bullion was in a bear market and had been in a bear market since last March when it hit just over $1000 an ounce. Although a degree of hostility was the reaction, the fact is that gold is now around $735. A decline of 27% qualifies as a bear market in my book.
As long as inflation remains a fact of life, gold will at some point make a bottom and renew its longer-term major uptrend because gold keeps up with inflation. I do not know when that will happen or even if it will happen, and if it happens I do not know how much inflation there will be. I am not predicting any of these things. I do not predict turning points. I wait until the market speaks and provides concrete signals that turning points have occurred. I do not predict. I observe. I observe that gold is currently trending down.
Markets do not know what we think. They can do anything. If I deny the downtrend, that will not change it. If I root for gold, the gold market will not hear me. If I hope for the dollar to flame out, that will not do anything.
This article does not analyze the shortage of coin for immediate delivery. If these coin shortages mean that gold bullion is going to wake up and start rising, then the bear market will cease and all those who have bought bullion on the basis of this discrepancy will profit. It is possible that mints will buy gold bars at $735, mint them into coin, and resell them at $1000 an ounce. This may hold the price of gold up. It may also be holding up bullion's price now, so that if and when the coin demand abates, bullion will fall. There are many such factors that are beyond my scope.
The case I will make for gold's being overvalued rests on its relations to other goods. I compare it first to consumer prices. I began this work in a roundabout way. Years ago my family had a meat market and grocery store. One of our suppliers published a weekly list of items and their prices. My brother recently came across one of these lists from 1967. I wondered how inaccurate the government's consumer price index might be, so I extracted some items from the book and compared their prices with today's. The idea was to find as nearly as possible the same exact items, holding constant the weights of the product. The following 10 items are a sample (with some prices rounded.)
The average inflation factor of these items is 5.75.
- Apple jelly was $0.40 and is now $2.48. Up by a factor of 6.2.
- Red raspberry preserves were $0.55 and are now $3.00. Up by a factor of 5.5
- Jif peanut butter was $0.60 and is now $2.37. Up by a factor of 4.
- Skippy peanut butter was $0.61 and is now $2.71. Up by a factor of 4.4.
- Mazola was $3.07 and is now $13.59. Up by a factor of 4.4.
- Pompeiian olive oil was $0.49 and is now $4.08. Up by a factor of 8.3.
- Crisco shortening was $0.95 and is now $5.18. Up by a factor of 5.5.
- Carnation evaporated milk was $0.19 and is now $1.17. Up by a factor of 6.2.
- Borden condensed milk was $0.42 and is now $3.04. Up by a factor of 7.2.
- Nestle's morsels were $0.55 and are now $3.21. Up by a factor of 5.8.
The CPI calculator here shows that $1 in 1967 is $6.15 in 2007. This is not far from the small sample of groceries. In fact, I paid something like $3,000 to $3,200 for a new 1970 Plymouth 4-door sedan, and very nearly the same inflation-adjusted price for a new 2003 Toyota Camry 4-door automobile. The Toyota is a better quality vehicle.
We can argue all day long about inflation being more than what the government says. It is a very difficult matter, especially when there is quality variation and when no two persons have the same market bundle. There are all sorts of arguments that can be brought in to this debate. There are hundreds and thousands of new products. There are products whose prices have dropped dramatically, and others that have gone up by a factor of 10 or more. In the end, I believe that the CPI figures are not so wildly inaccurate that they should be discarded. I will use them. You can always adjust them for yourselves, in which case your gold price estimates will differ from mine.
The general idea of the first estimate I will do is to establish what seem to be equilibrium prices of gold at two dates in the past (I use 1975–1978 and 1994), and then to apply CPI inflation factors to those prices. I need to explain why I choose these dates.
After Nixon took the U.S. off gold completely in 1971, gold started to rise. We really cannot take the 1967 price, which was under $40, as being a good measure of the free market price of gold back then. Gold rose steadily. By 1974 to 1977, the price had stabilized. Its annual average prices were $159 in 1974, $161 in 1975, $125 in 1976, and $148 in 1977. This stability suggests to me that prices had equilibrated.
I will use a price of $148 in 1977 as one equilibrium price.
Gold then embarked on a price rise replete with fluctuations of significant size. In 1980 it soared briefly to $800 only to fall quickly back to $500 on its way down to $300. This huge volatility cannot be used to extract an equilibrium price. But a price chart from 1982 to 1996 reveals a very interesting thing. Gold at first oscillated between $300 and $500. Gradually the oscillations died down and by 1994–1996, gold had settled down to a very stable price. It averaged $384 in both 1994 and 1995 and $388 in 1996.
I will use a price of $384 in 1994 as an equilibrium price.
The fascinating thing is that the 1977 and 1994 prices, both of which are periods of gold price stability, are in accord with the rise in the CPI over that period. The CPI went up by a factor of 2.45 between 1977 and 1994. If we multiply $148 by 2.45, we get $362.60. This is very close to gold's actual price of $384.
Now we can project a 2008 price. There are several ways to do this. Start with $384 and multiply by the inflation factor between 1994 and 2008 of 1.43. This gives a 2008 price of $549. Alternatively, start with gold's $148 price and multiply by the inflation factor of 3.50 between 1977 and 2008. That gives a 2008 gold price of $518.
Gold was $159 in 1974 and $125 in 1976. If we use those as starting points, we get 2008 prices of $687 and $467.50. These average $577.25.
We now have estimates of $518, $549, and $577. These average $548.
Rounding, I take $550 to be an estimate of gold's 2008 price that is consistent with the CPI index. This calculation is supported by the fact that the rather stable price of gold in 1994 grew from a stable price in 1977 and that the growth rate tracked the growth rate of the CPI index between 1977 and 1994.
Another very simple approach that does not use the CPI at all is to find a linear or arithmetic trend between 1977 and 1994 and project that trend forward. Gold rose from $148 to $384 in those 17 years or $13.88 a year. Over the next 14 years, similar increases would add up to $194. That gives a projected 2008 price of $384 + $194 = $578.
The next approach I use is to relate gold's price to the prices of base metals. Copper, zinc, nickel, aluminum, and lead all rose substantially along with gold between 2003–2005 and 2008. They were all part of the commodity price rise. Now all of these metals have fallen back sharply. They are either back to their 2003–2005 levels or getting quite close. If gold mimics their behavior, then gold will return to its 2003–2005 level. That level is about $400.
Silver is back to its early 2006 level. Gold was $550 in early 2006.
Now, of course, we can bring in all sorts of other bullish and bearish considerations. The base metals and silver have industrial uses and they may be falling more because of that. Gold may be unique in its response to the credit breakdown. We may argue that the deflation will be so severe that it will bring down gold's price. We can argue that the severe drop in gold-mining shares suggests a much lower gold price; however, that requires much more analysis since gold and gold-mining shares often diverge in price.
My analysis here is incomplete. I am not providing bottom-line advice for gold investors that weighs all the possible arguments. I am sharing input to the gold decision that is, as far as I know, unique among published reports in both results and methods used. The findings differ from my first article on the subject wherein I estimated a price of $656 using M1 money supply and $1,099 using the monetary base.
I have found that a value of gold of $550 for 2008 is both reasonable and consistent with the rate of increase in consumer prices over long periods of time. A long-term arithmetic linear trend suggests a price of $578. Gold's recent relation to silver suggests a price of $550. Gold's recent relations to other base metals suggest a price of $400.
Since gold is now $735 and in a bearish trend, it seems to me that it is going down for good reason and that the price decline can go further based on the fundamentals considered here. What new events may transpire tomorrow that may affect gold's price are not guessed at here.
JUNK GETS JUNKIER
Forbes fixed income columnist Marilyn Cohen warned people away from low grade credit when the spread over Treasurys got absurdly low in 2005. From an ultimate low of 2.1 percentage points, and at still less than 3 earlier this year, the spread has rocketed to 12 recently. Time to buy? Not yet, she says, with worse news still to come.
With short-term U.S. Treasury yield miniscule, what, then, is the fixed income investor to buy? Cohen recommends select corporates yielding 5-7% maturing in the next 3 to 5 years. We think inflation will start to pick up markedly well before then, but where fixed income investments are appropriate this sounds like a plan.
Bond investors do not know where to turn anymore. Just about anything other than Treasury paper has gotten beaten up this year. I keep hearing in my mind the words to a 1965 Martha and the Vandellas hit, "Got nowhere to run to, baby, nowhere to hide."
People who own junk bonds are especially hurting, as yield spreads over Treasurys have widened to 12 percentage points. That has sent high-yield prices down 29% for the year, according to Merrill Lynch (total return: minus 23%). Not quite four years ago in this space I advised staying away from junk because its yield advantage over Treasurys was a meager three percentage points or so ("Junk: Not Worth It," January 10, 2005). I was just slightly early; the junk bubble continued as the spread to Treasurys narrowed to 2.1 percentage points, its most absurd, the following month.
Since that low point the junk spread has taken off (see chart below). Does that make the category a buy now? Not quite. We are headed into a recession, and the default rate on junk could surpass 10% next year. I would hold off purchasing, until either spreads widen still more or an economic resurgence is in sight.
I have been more bullish on investment-grade corporate bonds, but even those are having a bad year, their worst since 1994. Their extra yield over Treasurys is 5%. That is enough to make them a modest buy now, but keep maturities short and credit quality high in your portfolio. ...
It is okay to save some cash for bargain hunting later this year, but do not cower with all your fixed-income money in T-bills. Put some of it to work in fairly safe corporates that offer the prospect of beating inflation. Here are three issues to consider.
First, General Mills (NYSE: GIS). Its brands include such staples of America's pantries as Betty Crocker, Cheerios, Green Giant, Hamburger Helper, Häagen-Dazs and Wheaties. The General Mills 5.25% due Aug. 15, 2013 is a $700 million issue. Standard & Poor's rates it BBB+. It is currently priced at 94 for a 6.66% yield to maturity. I think commodity prices will stay depressed and help food packers maintain their profits.
IBM (NYSE: IBM) was one of the few corporations able to market new bonds this October. It sold 5-, 10- and 30-year maturities. Buy the IBM 5-year 6.5% due Oct. 15, 2013. With an expected A+ Standard & Poor's rating, the $1.4 billion issue is priced at 102 to yield 6%. Minimum purchase, $100,000.
Finally, look at the FedEx (NYSE: FDX) 7.25% due Feb. 15, 2011. It is a $244 million issue that Standard & Poor's rates BBB. The bonds trade at 100.5 to yield 7% to maturity. No matter how much jet fuel costs, no matter how steep the economic downturn gets, FedEx will handle the job. Certainly shipments will decline during this part of the business cycle, but FedEx has been through downturns before and always landed safely. That is why I think you can confidently add this bond to your portfolio, and its short maturity should help assuage any inflationary fears you may have.
Although the present credit crisis is deflationary, investors know that at some point after it passes the country will be tempted to inflate its way out of oppressive debts. Owning short-term bonds of the sort I recommend here will allow you to cope with this problem by reinvesting principal at higher yields.
A LONG TIME BEAR TURNS TO STOCKS
Longtime sourpuss Andrew Smithers tells why he has turned, if somewhat grudgingly, to stocks.
After a steep stock market selloff there will be no shortage of kibitzers in the pick-the-bottom game. But when someone who has been bearish on stocks for going on a decade says we are getting near a bottom, and that those with "long term" time horizons -- we are talking decades, not years -- should start reentering the market, then perhaps one might grant the opinion some weight.
Andrew Smithers believes stocks could fall further when everyone sees just how badly corporate profits suffer. This has not dissuaded the college endowment which Smithers advises to borrow money and start using it to buy stocks. The college has kept some dry powder, and would become fulling invested if the S&P fell to 700. (This is written Tuesday evening after a substantial market rally brought the S&P to 940, so that would mean a 25% fall from here.)
Andrew Smithers was, for years, one of London's most dependable bears. In 1999 he told his alma mater, the University of Cambridge's Clare College, to get out of stocks. He kept up the bearish attack in a book he coauthored that was serendipitously published in March 2000 -- the month the Nasdaq stock market peaked. In September 2002, when the S&P 500 was at 916.07, off 40% from its peak, he was telling Forbes that stocks still were not cheap enough to buy. He said stocks were overvalued by a third. In July 2007 he told the 100 or so clients of Smithers & Co. that prices were going to fall as credit tightened and corporate share buybacks came to an end.
Smithers is not just gloating now, with U.S. stocks off 37% in the past year and a widely quoted index of European stocks down nearly 50% in dollar terms. He is bullish. He recommends that patient investorss -- those with a horizon of a few decades -- start getting back into equities.
Smithers, 71, spent 27 years at the British investment bank S.G. Warburg (now part of UBS), eventually running its investment operation. In 1961, after studying the economic history of India and Japan at Cambridge, Smithers started buying Japanese shares, convinced that its market was on track to explode because the country had highly educated people and a shortage of capital. He worked in Japan for Warburg starting in 1986, then left the country in 1989, not long before the Nikkei peaked at 38,915. It was a period that shapes his views. Toward the finale of the Japanese bubble he heard people saying that home prices would never go down. He was hearing the same thing from U.S. home buyers two years ago.
In 1989 Smithers opened his own firm, with 12 institutions as clients. And now he tells us that his qualified bullishness is not out of character. "I am a natural optimist," he insists, noting that while his valuation work showed that stocks were overpriced for some time, he turned bearish only last summer, when he called for prices to fall.
He believes shares have room to fall further over the next six months or more as profit forecasts disappoint and corporate buyers of stocks switch and become sellers of shares. "I think there are going to be some unpleasant profit stories which people are not expecting and the market will have a negative reaction," he says.
Smithers lambasted the first bailout plan offered by Treasury Secretary Henry Paulson, the one centered on buying bad mortgage paper. Now he thinks governments are on the right track with their efforts to inject equity into banks. He is not worried the public spending spree will trigger inflation. However, he warns that a second round of bailouts may be required.
Clare College, where Smithers sits on the investment committee, is buying on margin. The college's £60 million ($104 million) endowment borrowed £15 million for 40 years to invest in stocks. On October 10, as stocks crashed, the college put £2 million to work, buying into Japan's Nikkei stock index at 8,290 and the S&P at a little over 900. Smithers does not see much point to stock picking, so the college is using index funds. The present plan is to dribble the money in, but if the S&P sinks to 700 it would put all its chips on the table.
"Bear markets tend to last for a long time," says Smithers. "This one started in 2000, so we may have only a couple of years to go. But we are getting to values where we could see good long-term returns."
DIVIDEND INVESTING FOR AN EMPIRE IN DECLINE
This past year's market rout has reacquainted people with the value of such age-old concepts as margin of safety and the virtues of an overall defensive approach to one's stock investing. And emphasizing dividends -- as in cash in hand now versus speculative future capital gains ... those dividends -- is one conservative strategy.
The fact is that if a stock falls 75% after you buy it, if you bought it for its income, i.e., its dividend yield, and -- BIG "and" -- the dividend is not cut, the stock's value to you is unchanged. Sure, being human you would kick yourself for not having waited to buy until it had even more value to you, but that is a different issue. Alternatively expressed, the stock's value changes when the dividend changes, not when its price changes. When this idea is kept foremost in mind, the investment approach is to maximize your income from your investments over time. In practice this means to look for stocks with high, secure and growing dividends.
Ralph Shive, lead manager of First Source Monogram Income Equity, takes exactly such an approach. His results, coming in at #2 among all large capitalization value managers for the past 3 years, according to Morningstar, and #1 over both the past 5 and 10 years, indicate he knows what he is doing. This interesting interview by Forbes elucidates Shive's investment strategy further, in general and as it applies today.
Ralph Shive thinks America's best days are behind it. The country has peaked, he thinks, and is preparing for a period of bitter decay. That depressing outlook guides the longtime money manager's investment thesis: He is staying defensive, committing capital to what he sees as big, stable, safe companies.
Investors might disagree with Shive's dim view of the nation, but they cannot quibble with the man's awesome performance as an investor. Shive is the lead manager of First Source Monogram Income Equity (FMIEX), a no-load fund that invests in what he deems to be undervalued stocks that pay sizable and stable dividends.
The 5-star, large-value fund has smoked the competition. Through October 22, FMIEX scored the #2 spot in the Morningstar "Large Value" category for the 3-year period, and it is the top-ranked fund for both the 5-year and 10-year periods. FMIEX's 10-year annualized return of 9.79% tops its peer average by 5.63 percentage points and zips past the S&P 500 by 6.73 percentage points.
According to TRS, an independent research firm that tracks the career performance records of portfolio managers based on their stock-picking, consistency and risk profiles, Shive is ranked #44 of 7,000 managers.
Forbes.com recently spoke with Shive from his office in South Bend, Indiana, to talk about his outlook on the market, the economy and which companies he thinks now make for prudent investments.
Forbes.com: Warren Buffett says it is time to buy. You agree?
Shive: Well, I am always in the market. I have had cash at about 15% going on five quarters now. So I am still concerned and defensive. The main theme here is bigger, safer and higher-quality companies. That has to be the theme when you are in a bear market. The weaker ones get wiped out. I missed most of the housing and mortgage problems, but I have problems all over the place now.
Explain your investment strategy.
I generally follow the traditional value strategy: low P/E, low price-to-cash flow. I am pretty eclectic, though. I am maybe a bit more flexible than some firms. I am not real market-cap sensitive. Every stock does not need a dividend yield, but I do want my portfolio to yield well above the S&P 500.
How do you determine when a stock is "cheap"? Which statistical metrics are you using? Price-to-book value, price-to-cash flow, price-to-sales?
Yes, yes and yes. We use them all. Price-to-book used to be pretty good in the financial sector. Then we found out the book values were bags of air. You have to watch goodwill. We also look at cash flow, dividends and valuation relative to long time periods.
Why do you look for companies with above-average dividend yields? What does that tell you about the company, as an investor?
You do not just buy yield for yield. People were doing that with financials. They were not seeing the macro picture. You want the stability of the dividend. But you have to like the company and the outlook. You have a higher probability of returns with a dividend than you do with share-price appreciation.
Of the 7,000 companies the S&P follows, 138 decreased their dividend during the third-quarter. That is compared to 21 that decreased their dividend in the year-ago period. S&P says it was the worst September for dividends since it started keeping dividend records in 1956. So, in this kind of environment, how do investors know if their dividends are safe?
It is very difficult in the financials. I have had two life-insurance companies recently reduce their dividends on me: Lincoln National and Hartford Financial Services. I have been around long enough to remember that back in the 1980s, a lot of industrials went through a tough time. Many of the industrial companies cut their dividends. This time, the center of the storm is the financials. That is the epicenter of the problem. But I feel better about consumer staples, energy and industrials. They are paying their dividends. The financial space is suspect.
What metric can we use? The payout ratio?
Yes, I want to know where it is. It depends on how stable their earnings are. Pfizer does have a pretty high payout ratio, but it has high cash flow and a fairly stable business. Commodity companies have more volatile earnings. Of course, financials, 12 months ago, we all thought those were stable, safe dividends across the board. It has been carnage in that space.
If Barack Obama becomes president, we can expect taxes on dividends to go up. How does that change the calculus for you? Will that take the luster out of dividend-paying stocks a bit?
No, I do not put much weight in that probable outcome. First, with the market stress, the principal remains the same: Cash in the hand is worth more than the idea that maybe the stock price goes up. It is still valuable from the stability standpoint. What will he implement? I have no idea. The lobbyists will beat him up.
But, listen, we need savings. We need incentives to save. We have a borrowing problem. That is the problem with our country. We are a debtor nation. The average consumer has not saved enough. We need incentives. Low tax rates are one of them. I also think we need corporations to be sharing with their shareholders. I would disagree with the policy if it were to change. The same goes with [capital] gains.
Do you like any exchange-traded funds that track dividend aristocrats? Like the iShares Dow Jones Select Dividend?
I do not touch ETFs. I like real companies. I want to know what companies I am buying. And I want my clients to know what companies I own. No ETFs.
Won't it be harder to find companies with above-average dividend yields? In a weak economy, won't companies be more prone to conserve cash?
There are companies with stable businesses and relatively low debt that should able to continue to increase dividends. A lot of companies may curtail stock buybacks, which is not a return of cash to shareholders; it is just working on the number of outstanding shares in the corporation.
On a macro level, this will be a severe, hard recession. Corporate earnings will come down more in 2009. So the dividend increases will be probably truncated. But if we could get any kind of confidence that the world is stabilizing, there are all kinds of companies that yield more than CDs and 10 times more than Treasury bills. If we can get stabilization, the yields are damn attractive on common stocks for companies you think can keep paying them or increase them a bit.
There were two sector reversals that hurt the fund's relative performance in the third quarter. Let us discuss them. First, you had been underweight financials for some time, but Uncle Sam stepped in and helped the group bottom in July. What are your thoughts now on that sector?
I have grave concerns about the industry over the next three years. We are not getting out of this overnight. This is like the dot-com bubble in that the groups that got excessively euphoric and expands -- when they break, they do not lead the next up cycle, even though, traditionally, financials should lead. But this is a total panic breakdown. There will be new rules and regulations. You will have some survivors. You can rifle-shoot to pick winners. Overall, as a group, it will not be a leader in the next bull market.
Let's talk about some of the financials where you spot opportunity. JPMorgan Chase makes your top 10. How come?
I believe they have been anointed by the government to be a survivor. I just bought Bank of America for the same reason. They are picking up assets on the cheap. But these two are big survivors. That is the theme.
What do you think of Jamie Dimon [chief executive of JPMorgan Chase]?
He is one of the better managers at the big banks. I think Ken Lewis [chief executive of Bank of America] is a pretty savvy banker also.
The fund had been overweight industrials, a play that worked well for several years. Why did that sector come under such intense selling pressure in the third quarter?
I believe it was the realization that this is a global bear market. Exports will diminish. Also, the dollar rally hurts them at the margin. Industrials do make necessary things. But, in a recession, their business will obviously be hurt. It will slow down. They had held up the best. But, ultimately, the bear market gets them all before it is done.
I see that you have also lightened up some on energy. Is that just because some of the stock prices pushed through your fair value estimates?
Right, they got too full for me. It looked crowded. I backed off buying. They became a smaller percentage. I still like Anadarko Petroleum, Marathon Oil and Schlumberger.
Let's go over some of your other holdings. Your top position is in Johnson & Johnson. How come?
It is simple: big, safe, diversified. We have liked consumer staples over consumer discretionary for a long time. We knew this housing thing was going to smack the consumer hard. And it has. Now, I did not know that it would take down the financial world. But it is up in my top 10 because it has been outperforming.
What about these patent expirations plaguing the pharmaceutical division? Will those not limit growth and operating margins?
I own a bunch of pharmaceuticals. That is standard with them all. These are less bad than other stocks. That is a sad thing to say. But I just think they are more stable and safer than others.
You also like Allstate?
It is big. I had thought they were pretty safe. I wanted to own something in the financial area. So that has been one named I added to. I do not think they were doing anything too stupid, like AIG. But then again, it is pretty hard to know these days.
Explain to us why you are still a fan of General Electric.
I am a fan. I like the industrials. I knew that GE Capital has been a growth driver. But look at the valuation -- it used to be trading at 40 times earnings. Now they have disappointed a couple times this year. But they are big and diversified. They make the things the world needs. I think it is a well-managed company.
And Eli Lilly?
That has been disappointing. It was not as stable as I thought. They have been making some big bets on keeping the growth alive over the last couple years. It is not certain that it is working. The Street does not seem to believe it. The yield is big. The cash flow is there to pay it. But it is certainly struggling.
I also like Pfizer and Novartis. I look at my pharmaceuticals as a package of consumer staples. You can call them health care. But they are not discretionary. There is some evidence that people are backing off in hard times. But baby boomers are getting older. I cannot imagine these industries going away. They are leaders and financially strong, pretty much. It is better than a consumer discretionary. Because you do not have to go to a restaurant or go to a mall and buy crap from China. But you do need to take your meds.
What is your sell strategy?
There are a couple angles. It could meet my price target. That is the good part. Or maybe I find better ideas. I plan ideas looking out two or three years. I give them a shot. But sometimes my patience wears out. I find a better idea and they get replaced. Lastly, I try to truncate pain and suffering from bad ideas. You have to admit the idea is not working. I am better at that now than when I was younger. I do not fall in love with stocks or companies. They are investment ideas. I am not palling around with any CEOs. They are investments for my clients. If I am wrong, then I move on.
Can you tell us about stocks you have eliminated recently?
Two bad ones this year were Motorola and Sprint. I was way late on eliminating them. I am not happy about it. But I am happy I sold them.
In your spare time, you are an avid reader. One of your all-time favorites is Wealth and Democracy: A Political History of the American Rich by Kevin Phillips. How come?
I love history. I try to understand cycles, which help me envision where we are now and where we might be going. That book was a great recap of the rise and fall of great nations. The United States is a great nation. We are, in my opinion, peaking and preparing for decay. We have already been decaying.
I found the book fascinating. He pointed out that, in peaking nations, we turn into paper shufflers. Young and hungry countries are mercantilists. They create and sell. But peaking nations shuffle paper. That is what we do here now in America. We shuffle Collateralized Debt Obligations and Credit Default Swaps all over the globe. And this is what it gets us, this mess.
How does that world view influence your work as a professional money manager?
I am more defensive. I think about a slow-growth, problematic environment. I may need a more niche-oriented philosophy. In a broad, growing market, many industries are doing well. In a slowing, decaying market, there are fewer winners. You need to ask whether your companies are winners in a slow environment. Do they have the financial strength? The distribution? The technology? So it makes me more conservative. Also, in a slow growth stock market, the yield part is a nice component.
What do you like about value investing? What do you particularly appreciate about this style?
First, it works. It makes money. Also, it fits my personality. I am kind of a contrarian. I like to buy things cheap, on sale. It suits me. Momentum guys probably have a different personality than me. I have seen the hot, sexy stuff blow up so much. I think it is a better philosophy to buy them when people hate them.
As a professional investor, what is the benefit of living out there in South Bend instead of here in Gotham?
I like being off Wall Street. It helps me. It gives me clearer thinking. I am less influenced by the crowd.
Hedge Fund Model Will Be Rethought
Prime suspect in the current round of market distress is forced liquidations by hedge funds. This week's Barron's hedge fund column cites a JPMorgan estimate that redemption requests for funds-of-hedge-funds reached about $100 billion in the fourth quarter, and that $400 billion of positions would be unwound in the coming year.
Hedge funds are supposed to hedge one's market exposure but instead collapsed along with the market, some of them falling to zero. "A lot of smaller funds were leveraged beta masquerading as alpha," was how Gifford Combs, managing director at Dalton Investments, put it. Hedge funds are illiquid and you get charged high fees as well. What a deal! Consequently, many investors will rethink the wisdom of their exposure to the so-called sector -- which is not a valid independent asset class, in our opinion. Samir Sinha, lead portfolio manager at the Mockingbird Value Fund, believes hedge funds might become more like private-equity funds, investing in turnaround situations or private companies that might go public in three to five years. This makes sense. Many will go out of business.
Sinha finds compelling valuations in the U.S., but is looking for what sound like October 1974-like valuations in the "GEs of tomorrow" overseas, in economies with "tailwinds." Combs is sticking closer to home.
The future looks bleak, but some see a bonanza for those with some cash. "There are compelling valuations for a basket of strong companies" likely to grow in the next five to 10 years, claims Sinha. "Buying a GE at a price-to-earnings multiple around 10 is very cheap; it is one of the best companies in the U.S.," he says. But he is looking for "the GEs of tomorrow," trading at multiples of three or five times earnings.
And he is looking overseas. In 2007, the U.S. and other economies decoupled, with those of Brazil, Russia, India and China heating up. That is no longer the case, but the cooling down has been overdone. "Valuations have gone too far the other way," Sinha says.
The key is to "bet on economies with a tailwind" in the next five to 10 years. The U.S. does not fit that bill, he says, because interest rates here are likely to trend flat or higher in that span. "Historically, rising rates have not been a tailwind for stocks," he says.
Dalton's Combs plays it closer to home. "You buy when people are panicking," he says, noting that some sectors and stocks are down 50% to 60%, while the broad market is down 20%. "Almost certainly, we are heading into a severe consumer-led recession," Combs says. But P/E ratios "are the best" -- that is, the cheapest -- since the dot-com bubble burst at the start of the decade. Every [investment] idea I put on a legal pad, one idea per line," he says. "A year ago, there weren't 10 items. Now I have pages." Sounds like a good indicator to us.
What Is a Bear Supposed to Do?
Rick Ackerman interprets the huge rally of Tuesday, October 28, as (a) a short squeeze and (b) a little note from "Mr. Market" that it is not easy making money even on sure things.
Years from now, when the Dow Average is wallowing below 3000 and we hear some windbag brag about how he made a fortune shorting the bear market the whole way down, we will remind him of the short squeeze that occurred on October 28, 2008. The rally was Mr. Market's way of telling bears that it is not always possible, let alone easy, to make a pile of dough by betting on the sure thing. And we do think that the ongoing collapse of the stock market is a sure thing, even if there will always be interruptions such as yesterday's. But when the hubris dies down, stocks will still be in a bear market, the economy will still be slipping into the deepest bog since the 1930s, most of the largest banks in the world will still be verging on failure, home prices will still be dropping like a brick, and credit deflation will still be threatening to asphyxiate borrowers and lenders alike.
In short, nothing will have changed -- even if Kudlow is saying that the stock market, supposedly prescient as always, has glimpsed recovery in 2009. In fact, the stock market is about as prescient as a meatloaf, and nascent bull markets do not so much predict economic recoveries as engender the psychological changes that cause them. We are confident this cyclical turn will occur eventually -- just not before the Kondratiev cycle's scheduled bottom around 2015. In the meantime, we would suggest that speculators do breathing exercises while contemplating a monthly chart of the Dow Industrials. Note in candlestick rendition above that Tuesday's maniacal short-squeeze did not recoup even half of October losses represented by the final bar. That would require yet another thrust to at least 9368 -- 303 points above Tuesday's settlement price.
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